Although you’ve probably used banking products and services such as checking accounts, savings accounts, and loans, do you know how banks make money and how to translate that into investment opportunity?
The money business doesn’t work quite like other businesses. Unlike other companies that sell products or services, banks buy and sell money. A dollar is a dollar, so how do banks make a profit? By charging a higher interest rate for the money they loan out than they pay for the money that comes in as deposits and by charging fees for the money-related services they offer. Because of this difference in business model, banks use a few financial measures you won’t see for other companies. However, taking the extra steps to study banks is worth your while—financial stocks can grow quite well and are a great way to diversify your portfolio.
Banks come in several flavors, each with its own unique blend of pros and cons:
These banks borrow from and lend to governments, large corporations, and other banks. They offer no consumer banking functions. Money-center banks can deliver more consistent earnings than other types of banks due to their large bases of operations. However, their sheer size can limit how quickly they grow. They are also vulnerable to losses from big corporate and international loans.
These are commercial banks that specialize in lending money to corporations for investment activities, such as initial public offerings and leveraged buyouts. Investment banks are also vulnerable to losses from corporate and international loans.
Regional banks confine their operations to one part of the country and typically lend to mid- and small-sized businesses. These banks offer consumer banking services. Regional banks are popular with investors, because they offer higher growth rates than other types of banks and are sometimes acquired by money-center banks. Regional banks looking to expand often acquire smaller savings banks and savings and loans.
Also known as thrifts or S&Ls, these institutions are owned either by shareholders or customers. Savings and loans offer both consumer and commercial banking services and were originally chartered to supply funds for building, buying, and remodeling homes.
Banks and S&Ls are chartered either by the federal government or state governments, and are regulated by the Federal Deposit Insurance Corporation (FDIC), the Comptroller of the Currency, or state regulators. Bank examiners visit institutions every year to ensure that they use sound operating procedures and have sufficient operating capital. Despite this regulation, banks and S&Ls aren’t immune to failure. More than 1,000 S&Ls failed during the late 1980s and early 1990s because of mismanagement and outright fraud, combined with a poor economy, lax regulations, and intense competition in the banking industry.
A bank buys your money when it accepts your deposit, and pays you interest for the use of your cash. A bank sells money when it loans out money from its deposits. A person or corporation that borrows money pays the bank interest and fees for the use of the money, and pledges to repay the money over a specific period of time. The bank’s profit on its money business, net interest income, comes from the difference between the interest that the bank earns on its loans and investments and the interest it pays on deposit, checking, and certificate of deposit accounts, or funds it borrows from other sources. As the spread between these two types of interest rates—known as the net interest margin—increases, so do the bank’s profits.
Net interest margin is extremely interest-rate sensitive. When the Federal Reserve lowers interest rates, banks charge lower rates on loans and also pay lower rates on deposits. No impact to profits there. However, when interest rates are very low for a sustained period of time—as they were from 2000 to 2004—banks get squeezed because they have to pay some interest, however small, on their deposit accounts, while their interest rates on loans continue to dwindle. Competition also precludes banks from pushing their interest rate spreads too wide. Banks that depend on net interest margin can grow only by increasing the amount of money they loan, which carries its own set of risks as described in the next section.
Fortunately, banks can earn money from other sources besides buying and selling money: credit card fees and interest on credit cards they issue, safety deposit box fees, checking account fees, mortgage origination and servicing fees, and income from brokerage services. Collectively, these sources of revenue are known as non-interest income. Non-interest income can make banks more attractive as investments, because it is consistent and not sensitive to changes in interest rates. In addition, by developing additional products and services with commensurate fees, banks can grow their earnings without increasing their deposits or loan base. Many years ago, only a tiny percentage of a bank’s income came from non-interest sources. Now, analysts favor banks with a diversified base of non-interest income over those that derive most of their income from traditional banking activities.
You can check a bank’s proportion of net interest income to non-interest income to the sources of bank income. Calculate a ratio for interest income by dividing the net interest income value by the total revenue, as shown in Example 4-58. To see if a bank is moving toward more non-interest income, you can calculate this ratio for the past few years and look for a downward trend.
One additional component to bank income is the tax equivalent adjustment. Because some bank assets are held in tax-exempt securities, this adjustment increases the tax-exempt portion of interest income to the equivalent value in fully taxable interest income.
Example 4-56. Formula for bank revenue
Revenue = Net Interest Income + Tax Equiv. Adjustment + Non Interest Income - Loan Loss Provision
Example 4-57. Formula for net interest margin
Net Interest Margin = Interest Charged on Loans - Interest Paid on Deposits
Look for steadily increasing revenue just as you would for other types of companies. If you want to invest in a bank that isn’t as sensitive to interest rates, look for lower numbers in the interest/non-interest ratio. Net interest margin values are typically quite small; three to five percent isn’t uncommon. However, because very small changes in net interest margin result in huge changes in profits, look for banks that deliver above-industry-average margins. In addition, calculate the bank’s net interest margin for the past several years to watch for downward trends that lead to lower profits and eventually lower stock price.
It’s inevitable that some of the loans that banks make will go bad. If a bank is too strict in its lending criteria, it might not have as many bad loans, but it also won’t be able to loan as much money out. Conversely, if a bank is too liberal when evaluating its borrowers, profits might boom initially but crash when too many borrowers can’t repay their loans. To make money with loans, banks must be careful, but not overly restrictive, in choosing their borrowers. Banks that carefully track late payments and stay on top of delinquent loans stand the best chance of getting their borrowers back on track and keeping their loans in the black.
The following measures help evaluate the impact of bad loans:
This is the amount of money that banks are required to set aside to cover potential loan losses. In a bank’s income statement, the loan loss provision is deducted from net interest income in much the same way as sales returns and allowances are deducted from gross sales in a manufacturing company.
If any money in the loan loss provision account hasn’t been used to cover bad loans by the end of a quarter, it transfers to the loan loss reserve account on the bank’s balance sheet. If a bank uses more money than was reserved in the loan loss provision, the deficit is taken out of the loan loss reserve account.
This ratio compares the loan loss provision to the bank’s total loan base. It is useful for comparing loan loss provisions between competing banks or over several years for the same bank.
This ratio compares the loan loss reserve to a bank’s total loans. It is useful for comparing loan loss reserves between competing banks or over several years for the same bank.
Non-performing assets are loans in which the interest is past due by 90 days or more, that are not being paid on schedule, or that are being paid at a reduced rate. To calculate the ratio, divide non-performing assets by total loans.
All three ratios are useful in assessing loan loss trends and actual loss experience. In setting a loan loss provision, a bank walks a fine line. When the loan loss provision ratio is too low, a bank might have to take a charge against earnings to bolster the provision. Conversely, when a bank sets aside too much money for loan losses, it removes some of its assets from income-producing activities, which cuts into profits. Banks usually set the provision and reserves based on their past experience and the current economic climate. Bank regulators can also require a bank to set aside additional amounts if they believe it is overexposed to potential loss. Although it’s good to see downward trends in the loan loss provision ratio or loan loss reserve ratio, these ratios might increase when the economy falters or a big client goes belly-up. When the non-performing assets ratio trends downward over time, the bank is doing a good job of keeping its bad loan exposure under control.
Banks don’t make a lot of money on individual transactions, but they work with such a large volume of money that a little bit of profit on each transaction adds up fast. Because banks carry so much debt, return on equity (ROE) [Hack #32] isn’t a good measure of profitability. The best measure of bank 236profitability and quality of management is return on assets (ROA), which measures how much money a bank makes on each dollar of assets. Compare a bank’s ROA [Hack #34] from year to year, as well as to industry average values or the values for specific competitors. Ideally, ROA should increase steadily or at least hold steady over a number of years. Don’t expect big increases, because the numbers aren’t that large to begin with. Quicken.com notes that the average ROA for the banking industry is 1.02 percent. Analysts consider banks that consistently deliver an ROA at or slightly above 2 percent as extremely well managed and highly profitable.
Data providers report bank data in different ways [Hack #15] , just as they do for other types of companies. Most data providers break out net interest income and non-interest income. Value Line doesn’t provide the tax equivalent adjustment or net interest margin. However, S&P data, obtained directly from S&P or through NAIC’s Online Premium Services, does. S&P calculates bank revenue by adding gross interest income and non-interest income. Unfortunately, gross interest income is more sensitive to interest rates than net interest income because it includes interest expense. You can obtain all the components of bank income by using bank quarterly and annual income statements [Hack #19] . Because of the differences in reporting methods, don’t mix and match data sources for your bank analyses.
If you want to invest in financial companies without getting up to speed on these additional measures, consider mutual funds that invest in financial services stocks. You won’t find a pure-play bank fund, but the Financials Funds category at Morningstar’s web site (http://www.morningstar.com) provides several options.. Funds that invest in one sector can be volatile, so be sure to diversify your portfolio [Hack #74] .
—Amy Crane and Bonnie Biafore